Section 01 Outlook 2022: A Lurch to Normalcy
At this same juncture last year, we contemplated life — and an economy — beyond COVID-19. At the time, vaccines were on the horizon, and markets were positively pricing in a “return to normal” come summer. We were optimistic about a continued recovery as the impact of COVID-19 faded. As we look back on 2021, we were mostly correct. The global economy has marched ahead, corporate earnings have knocked it out of the park, and markets climbed in tandem. However, COVID-19 remains part of our daily lives and continues to challenge both the economy and markets; we haven’t put the pandemic in the rear view yet. Still, we were correct in forecasting COVID-19’s diminished impact on growth. All one needs to do is contrast the economic impact of the emergence of the delta and omicron variants in 2021 with the deep, rapid market plunge that occurred in March 2020. The world has adapted to life during a pandemic, policymakers came through when it mattered, and advances in vaccines and other treatments have fundamentally shifted the environment since 2020.
As to 2022 and beyond, we anticipate we’ll continue lurching toward a pre-COVID-19 version of “normal.” Some of the adaptations we strengthened, such as hybrid work arrangements, delivery, and automation, will probably stick around long term not only because they made life safer during a pandemic; they also unlocked new economic efficiencies and consumer preferences. Other than a few subtle shifts in the way we live and work, 2022 won’t be drastically different than life was in 2019. However, the huge monetary and fiscal policy response coupled with rapidly evolving business and consumer preferences has created some oddities in equity and bond markets that we believe will unwind in 2022 (think the pure “stay-at-home” trade). In fact, we’ve already seen signs of that process unfolding through November and December.
Of course, we’re still not in a post-pandemic world. We have seen new variants of COVID-19 emerge — first delta, now omicron — which will make the march toward normalcy uneven and lurching, but the economy will continue making progress, nonetheless. While certain market distortions will be corrected, we believe there are still opportunities in 2022 for patient, value-oriented investors, focused on the long term.
A Transitory Shift in Spending
As we forecasted, both fiscal and monetary policymakers around the globe acted early and forcefully to counteract the economic consequences of COVID-19 and the accompanying containment strategies. Policymakers learned to act faster following the Great Recession, when, in hindsight, acting sooner and more aggressively could have eased some of the economic pain and hastened the recovery. Today, the massive infusion of liquidity and monetary largesse for the past nearly two years has cushioned consumer savings and continues to impact the economy and markets — for better or worse.
First, the good. Consumers in aggregate have deleveraged their balance sheets and have ample opportunity to spend in 2022. The consumer debt-to-net-worth ratio has fallen from nearly 24 percent in 2008 to 12 percent today. From an income statement perspective, the cost of the resulting debt relative to consumers’ disposable personal income is 13.8 percent, versus a 2008 high of 18 percent. While we believe this provides strong support for economic growth in 2022, it’s also yielded inflationary pressures that are paralyzing markets and dominating the news.
Over the past 7 months, inflation has surged to levels not seen since the 1990s, but that’s also the era when inflation began a consistent push lower and eventually fueled the last economic cycle’s deflationary worries that engulfed markets. The return of inflation has sparked a fierce debate in markets about how long this house guest will stick around. Are we simply in the first inning of a new inflationary regime, or is this just another pandemic-fueled distortion that’ll normalize as we do the same in the coming quarters?
We’re in the latter camp. The early stages of the pandemic halted large swathes of economic activity as social gathering restrictions rapidly shifted consumption patterns. Pre-COVID consumers spent 70 percent of their consumption basket on services, such as health care, recreation and food services (think things that often don’t arrive at ports); and 30 percent on goods, such as motor vehicles, furnishings, groceries and clothing. COVID-19 has changed behaviors and has shifted spending toward goods (now 35 percent) and away from services (now 65 percent).
As businesses reopened when conditions improved, demand for goods sprinted out of the gates and put immense stress on supply chains. It was a fertile environment for inflationary pressures to build. Most recently, personal consumption expenditures (PCE), the Federal Reserve’s preferred inflation index, clocked in at 5 percent year over year, with core PCE (which strips out volatile components like fuel and food) hitting 4.1 percent. While consumer spending well exceeds pre-COVID levels, it’s solely on the back of a 15.4 percent jump in goods spending. Services spending, on the other hand, has yet to return to pre-COVID levels. Eventually, as we continue to march toward more normalcy, consumer spending is likely to also revert closer to its pre-COVID split.
If we further parse PCE, we see more signs of goods-heavy spending driving current inflation higher. While services inflation has recently picked up some steam and now resides at 3.7 percent year over year, the bigger inflation story is goods spending. Overall inflation for goods is up 7.5 percent on an annual basis, which is a sharp departure from the past decade or so (since 2009), when goods inflation was flat overall and never exceeded 1.4 percent (YOY).
Within goods, the mismatch between durables (cars, washing machines, air conditioners, furnishings) and non-durables (food, clothing, gasoline) spending is another oddity. Durable goods prices have been in a persistent deflationary trend since 1995. Overall, the price index has fallen 40 percent from the mid-1995 high to April 2020, with an average year-over-year decline of nearly 1.9 percent. In the current environment, consumer shifts have driven durables prices 8.8 percent higher year over year.
So, when you dig deeper than headlines about inflation, you find it’s largely been fueled by durable goods spending. That begs the question: Is this spending trend permanent, or will durables spending fall back, closer to its 25-year trend? Remember, durables typically last consumers for a few years or even more than a decade. How often do you purchase a new dishwasher?
For this practical reason, we think durables spending will normalize and pull headline inflation lower with it. Data indicate that a shift in spending is already underway, as services spending markedly increased in Q3 while overall goods spending declined. As we entered the fourth quarter, the ISM services PMI notched its two highest readings dating back to 1997.
The Transitory Labor Market Shortage
Puzzlingly, companies are having a really hard time finding employees. During the Great Recession, jobs were in short supply, as the number of unemployed far outstripped openings. Today, there are roughly 3 million more job openings than unemployed individuals. This labor shortage has pushed wages higher and has made it difficult for businesses to match current demand. This is another underlying trend to feed inflation. Again, the question is, is this transitory or permanent?
Pre-COVID, labor participation was at 63.4 percent and rising atop moderate wage growth. Importantly, there was no indication then that we were near maximum employment — a key inflationary condition. Today, the labor participation rate has fallen to 61.8 percent. Is this maximum employment (is the economy out of slack), or are more people bound to return to work?
It is certainly possible that a portion of the workforce have the means to retire or permanently leave the labor market, but we find it hard to fathom that it represents a significant share of people. Before the pandemic, labor participation in the prime working cohort of 25- to 54-year-olds was at 83 percent and rising. In prior economic cycles, this rate reached 83.5 to 84.5 percent before we were at full employment with this key cohort. Today, that rate resides at 81.8 percent, yet another sign of slack in the economy.
That’s why we believe the labor market, too, will lurch back toward a long-term norm. The expiration of enhanced unemployment benefits in September, kids returning to school and businesses reopening have all been recent catalysts. The number of individuals collecting pandemic unemployment benefits, for example, peaked at 16.84 million in August 2020 and resided at 9.4 million a year later. Today this number is essentially 0, and it’s highly doubtful all 9 million of these individuals no longer need to work. The odds are pretty good they’ll search for jobs in the coming months. An improving labor market will help businesses meet demand, which will moderate prices into 2022.
Policymakers Seek a Gradual Return to Normal
As we expected, policymakers acted swiftly to combat the economic fallout from COVID-19. They’ve learned that unprecedented times require unprecedented measures, but now the Fed (and, hopefully, Congress) will reestablish a “non-emergency” framework for monetary and fiscal policy. We’re on that path already, but it’s going to lurch forward slowly.
At its recent policy meeting, the Fed announced plans to taper its $120 billion a month bond market purchases by $15 billion a month, putting it on pace to finish tapering by mid-2022. In recent testimony before the U.S. House of Representatives and Senate, Fed Chair Jerome Powell acknowledged inflationary pressures were broadening and that it would also consider tapering its bond buys at an accelerated pace. His comments spooked markets recently, as there are fears that this implies the Fed’s new primary focus is an old-school battle with inflation. We disagree.
Yes, Powell acknowledged inflationary pressures had built and retired the word “transitory,” but he did so because the word is opaque and open to many interpretations. However, the overall narrative hasn’t changed; the Fed does not believe current conditions will “leave a persistent, long-run string of higher inflation behind it.” The Fed’s focus remains on employment, not prices. The Fed will allow this business cycle to hum as long as the labor market is improving. Employment has shifted over the past years to being the Fed’s primary mandate, and it won’t jeopardize triggering recessionary pressures by raising rates too soon or too aggressively to fight inflation.
Market participants often don’t ask follow-up questions about the Fed’s policy projections. Will tapering, which is simply a return to a more normal policy, and a rate hike or two in 2022 really hamper economic growth to a high degree? We think the Fed’s actions will have a very modest impact on consumer and corporate fundamentals, especially since they are both incredibly strong right now. Even with the taper and a few rate hikes, financial conditions will still be highly accommodative and economic growth will continue to push forward.
On the fiscal spending side, the Build Back Better bill is up for grabs but is likely to pass. However, its scale has been greatly diminished. This is not a political comment, but it was likely wise to scale down spending given the inflationary pressures in the U.S. and around the world.
Bottom Line for 2022: Markets Will Normalize, Too
While we believe markets will normalize, it’s unlikely to be a steady ride. Equity markets are likely to be volatile in 2022, but a healthy economy should continue to pull them higher. Returns are likely to moderate and track actual earnings growth a little more closely, which means the sectors that lead the market should shift as some of the “oddities” are ironed out of valuations. That’s why we believe investors must broaden their horizons beyond U.S. Large Caps and growth and technology stocks.
At the most extreme, we have seen real interest rates plunge to their lowest levels ever. The 10-year Treasury relative to current levels of inflation is extremely negative. This, along with an injection of liquidity, has emboldened so-called investors to bid up companies that are rising solely based upon hopes, dreams, themes and memes. But dreams can sour, memes go viral only temporarily, and some of these outlier valuations are bound to normalize as liquidity tightens and investors pay closer attention to real earnings and cash flows. It may be a high hurdle for companies with seemingly infinite valuations.
Mature technology and growth stocks certainly have secular growth tailwinds and strong fundamentals. But how much success has been pulled forward by trade wars and COVID-19? We think a lot of this growth, and more, has already been factored in by market participants.
At the same time, there are sectors and markets trading
at extreme discounts to U.S. Large-Cap growth stocks. In 2022 we think investors will focus more on what they are paying for that growth (think valuation). In many ways, the situation today has echoes of the late 1990s, but with a few important differences. Back then, many of the largest growth companies weren’t as fundamentally strong as the big companies today. Back then, the Fed had just wrapped up tightening policy, and bonds across the interest rate spectrum yielded 6 percent. Today the Fed is just beginning a tightening cycle, and bonds yield roughly 1.5 percent.
But there are striking similarities. Back then, the U.S. equity market was similarly concentrated in a few technology stocks that enjoyed strong secular tailwinds, while nearly every other part of the U.S. stock market had dramatically underperformed. Value had dramatically underperformed growth, U.S. Small Caps and global markets had dramatically underperformed U.S. Large Caps. In the 1990s, retail investors surfed message boards and bid up stocks based upon fantasies of the future. The bullish messages from the retail crowd are the same today, though the message boards have certainly evolved.
History doesn’t precisely repeat itself, but it does echo. Our comments on valuations are not meant to cause concern but to provide food for thought and context. We’ve seen similar levels of conviction from investors before. While it led to some hard lessons in certain types of stocks when conviction faltered, there were still parts of the market that performed well throughout and after the dot.com bust. We think the same will remain true in 2022.
Section 02 Current Positioning
In June 2020, we scaled back our equity exposure from a near-maximum overweight position due to concerns about volatility we saw on the horizon. Still, we remain overweight equities versus fixed income, as we believe markets have further room to run in 2022.
We remain positioned for a continued economic recovery with above trend-line growth, and we are focused on pockets of the market that we believe are undervalued and underappreciated. Therefore, we favor U.S. value and cyclical asset classes, with our only U.S. overweight being in U.S. Small Caps, which are attractively valued and leveraged to our base case of continued strong economic growth. We are underweight REITs, but we moved positioning in the asset class from max underweight to slightly underweight in January 2021.
Within our international exposure, we reallocated capital from inflation- and rate-sensitive Emerging Markets toward International Developed stocks in June. Over the past few months, Emerging Markets have been hampered by not only central bank tightening but also fears of heavy government interventions in China (Emerging Markets are heavily tilted toward China) — all in addition to reinvigorated COVID-19 fears. We remain slightly overweight International Developed markets, with our exposure tilted toward the eurozone. The recent COVID-19 spike and potential for lockdowns in the region will likely be near-term headwinds to this position, but we still think an economic and earnings recovery will be a potent catalyst to push this relatively cheap market forward.
Section 03 Equities
U.S. Large Cap
Against a backdrop of growing worries such as COVID-19 variants, rising inflation, less accommodative monetary policy, and wavering consumer and investor confidence, the U.S. economy continues to plow forward. This economic resiliency has yielded sturdy market fundamentals. Specifically, for the last 12 months ending in Q3, companies in the S&P 500 in aggregate have seen top-line revenues jump 17.5 percent and bottom-line earnings pop 41 percent. That’s been enough to offset aforementioned headwinds. We expect strong macroeconomic conditions to persist into 2022, which we believe will continue to counterbalance tightening liquidity conditions. We remain neutral toward U.S. Large Cap given our belief that better valuation opportunities lie in other market segments.
While we returned our U.S. Mid-Cap outlook to neutral in June following impressive outperformance over the prior year, we remain optimistic that the asset class can be a solid performer over our intermediate-term investment horizon. Strong fundamentals aren’t unique to U.S. Large-Cap stocks, as U.S. Mid-Caps are putting up even stronger aggregate results. Year-over-year revenue growth for this asset class is up 20.4 percent, while earnings growth has clocked a sizzling 54 percent year-over-year jump. Shifts in investor sentiment and tightening monetary policy will likely impact this asset class more than higher-quality U.S. Large Caps, but a strong macroeconomic backdrop and valuation advantage will be a positive tailwind for U.S. Mid-Caps. We remain neutral but positively biased toward U.S. Mid-Cap equites.
U.S. Small Cap
Last quarter we described crosscurrents that were dampening investor sentiment and causing a rotation toward investments with less uncertainty. In Fixed Income that’s U.S. Treasurys, in currencies it’s the U.S. Dollar, and in equities it’s U.S. Large-Cap growth stocks. Early in Q4 these concerns eased, which helped U.S. Small Caps reestablish market leadership relative to their larger counterparts.
However, uncertainty is rising once again, as the omicron variant has raised questions about COVID’s trajectory and the Fed has shifted to a slightly more hawkish stance. As a result, U.S. Small Caps have lost ground relative to U.S. Large Caps. However, we believe this setback is temporary, and given our forecast, we expect U.S. Small Caps to have a strong 2022. U.S. Small Caps are at their largest discount to U.S. Large Caps since the late 1990s while delivering stronger fundamental results. Strong fundamentals and attractive relative valuations should eventually resonate with rational investors. We remain favorably inclined toward U.S Small Caps as we enter 2022.
International Developed markets around the globe were strengthening in November as measured by the IHS Markit Composite Purchasing Manager Indices (PMI). The eurozone, Australia and Japan all beat expectations. The eurozone composite PMI came in at 55.8 (anything above 50 indicates economic activity is expanding), up from October’s six-month low of 54.2. The reading was sharply higher due to an uptick in services sector activity. Australia’s composite PMI notched a five-month high of 55, supported by easing COVID-19 restrictions. Even Japan posted good growth, with composite PMI hitting 52.5. It’s the highest composite PMI reading for Japan since October 2018. Data clearly show developed economies are emerging from their pandemic malaise.
However, the recent rise in COVID-19 infections and hospitalizations could prove a temporary headwind to economic growth. Austria moved into a new lockdown; mobility restrictions have been implemented in Germany, the Netherlands and Ireland. More restrictions could be forthcoming due to the omicron variant, but we note these should be transitory thanks to economic adaptions along with vaccines and therapeutics.
Signs of weaker economic activity also increase the likelihood of extended monetary accommodation. In December, the European Central Bank is expected to delay announcing an end to its own asset purchase program. Alvin Liew, senior economist at United Overseas Bank, recently said, “The Bank of Japan will not be tightening anytime soon and will maintain its massive fiscal stimulus in the next few years, possibly at least until 2023.”
All the while, the discount for International Developed has widened relative to U.S. domestic markets. This typically happens in periods of weak eurozone growth. Despite omicron headwinds, we believe the European recovery will continue. Paired with a greater than 25 percent discount to U.S. stocks, we believe International Developed markets, specifically the eurozone, have the potential for attractive future returns.
As of end of November, Emerging Markets are about flat on the year, the worst-performing equity asset class that we invest in. Chinese equities, which are down more than 17 percent year to date, are a key detractor, as they account for over one-third of the index. The reasons for underperformance in China are twofold. First, regulatory crackdowns in the technology sector spooked investors, and the MSCI Emerging Markets Index is heavily weighted in Chinese tech names. The government also has a zero-tolerance policy on COVID-19, and in recent months those policies have triggered shutdowns that yielded new supply chain snafus. Throw in continuing property market concerns, and you’ve got a recipe for volatility.
In our view, while a zero-tolerance policy isn’t necessarily good for economic growth in the short run, it has generally helped control the spread of the virus. While much is still to be learned about the omicron variant, it is interesting to note that Chinese markets have been relative outperformers since news of the variant gained a foothold in late November. We remind that China was the one country that had positive GDP growth in 2020, as the country’s economy got back to a new type of “normal” more quickly than most of the world. The regulatory crackdown on tech is a big concern, but the Chinese government is also focused on growing the middle class, which can drive expansion via consumer spending and a gradual shift to a services-based economy. We believe investors who can look past the short-term regulatory issues can benefit through exposure to the world’s second-largest economy.
While it is not our base case, we must acknowledge that a more sustained long-term increase in inflation is a possibility moving into mid to late 2022. If this were to unfold, central banks in emerging markets would likely have to tighten monetary policy more quickly, thus creating an economic and market headwind. However, there are countervailing tailwinds for Emerging Markets. These economies are sensitive to rising global growth and should benefit from a broadening global economic recovery in 2022. Hopefully, vaccination rates will increase in these countries, and COVID-19 will lessen its grip on these economies.
Relative valuations are very attractive and currently sit at 20-year lows versus the developed world. As we look at Emerging Markets as a broad basket, they are expected to collectively grow at double the rate of the developed world over the next decade. Growth in these economies will be driven by an ascending middle class, the transition from manufacturing-based economies to services, and technology. Developing countries account for about 40 percent of world GDP and 25 percent of world equity markets, which means it’s important to have some exposure in a well-diversified portfolio.
When we look at this backdrop and account for future risks, we maintain our allocation at a slight overweight compared to our long-term strategic target.
Section 04 Fixed Income
U.S. Treasury yields have been on a roller coaster over the past few months. Yields pushed higher on rising inflationary concerns but quickly turned 180 degrees as omicron variant fears cast a shadow over economic growth. Throw in fears that the Fed is growing hawkish, and you have a recipe for a flattening Treasury yield curve (longer-term yields falling and shorter-term yields rising).
Lower yields are a logical outcome for those concerned about rising COVID-19 cases potentially causing economic growth to dampen. However, fears of a hawkish Fed pushing down long-term rates is perplexing and a challenge for markets to account for, and we believe the fate of longer-term Treasury yields will be decided in the coming months.
Investors have been conditioned over the past decade to react to any perceived Fed tightening signals by buying longer-term bonds. That’s based upon the thesis that the Fed would not only stamp out inflation but also tighten a “fragile” U.S. economy into recession.
Bond markets are debating two key questions going into 2022: Is the Fed really focused on stamping out inflation? Is the U.S. economy so fragile that it can’t handle multiple rate hikes?
We have stated our belief that the Fed is more concerned with employment and is in no hurry to aggressively quell inflation and risk harming the labor market. We also believe the U.S. economy is on much firmer footing during this economic cycle and thus can handle additional interest rate hikes. Over the past 13 years, tepid growth has caused the Fed’s long-term neutral interest rate to decline. If we are on the precipice of heightened economic growth, then it is likely that the neutral interest rate has risen. This rise would translate to an economy that can handle additional rate hikes, with a potentially higher ceiling on long-term interest rates.
This is an important conversation and difficult debate that will play out over the coming quarters. Given this uncertainty, we continue to favor an allocation to U.S. Treasury Inflation Protection Securities (TIPS). We note that much of the “easy returns” have been harvested here, as inflation expectations have firmed from their historical lows. Still, this is a worthwhile diversification instrument in a portfolio. Keep in mind that if inflation pulls back, it may cause TIPs to underperform; however, the reality is that the remaining parts of our portfolio may likely experience stronger performance. Put differently, to us the only chance this economic cycle ends prematurely is persistently higher inflation eventually causing a reluctant Fed to massively pivot. Until that time, the Fed is going to continue to let inflation run above trend to get more economic and employment growth and TIPS will likely benefit from this reality.
However, we must also be mindful of other risks. For these reasons we continue to position our overall duration near neutral and continue to favor higher-quality fixed income. We again implore investors to resist the urge to hunt for yield or higher returns by cutting exposure to safer Fixed Income assets. Every slice of the portfolio has a role to play, regardless of the market mood or economic environment. Don’t tear apart your portfolio based on short-term considerations. Fixed Income is not simply a vehicle for income generation but also one for risk mitigation.
Throughout 2021 we have favored modest duration relative to benchmark because the yield curve was relatively steep. While the curve has bounced around this year, mostly on COVID-19 spikes and tapering talks, it remains positively sloped, leaving our view of duration unchanged.
As of this writing, real rates are the most negative since the introduction of TIPS in the late 1990s. While “running inflation hot” has been the mantra for the Fed, we cannot entirely rule out the possibility that heightened inflation could trigger more aggressive policies in 2022. This would further flatten the yield curve by raising front-end interest rates more sharply than intermediate- to longer-term rates. As of this writing, the term structure of interest rates remains favorable in many potential future states. While modest duration could add some volatility to the Fixed Income portion of client portfolios, the term structure compensates you for time, and the duration can act as a hedge versus other risk assets. Keep it high quality, as lower-rated credits tend to have “hiccups” during Fed tightening cycles.
The U.S. dollar has been on a run since Q2 2021, likely due to increasing Fed hawkishness. While U.S. real rates are currently extremely negative, which is generally counter-intuitive to a strong dollar, we believe this could foreshadow the potential for real rates becoming less negative. Think inflation settling down while economic growth continues. We continue to favor U.S. dollar-denominated securities.
With talk of the Fed tightening picking up, high-yield credit spreads are at their widest levels of the year. As with Fixed Income in general, there are a variety of crosscurrents sending mixed messages. With rates so low in real terms, credit should be doing quite well as inflation and low nominal rates reduce hurdle rates of debt service for marginal credits. This is counterbalanced by a Fed that could become more active in 2022. Given these uncertainties, the current low level of credit-sensitive bonds and our willingness to take equity risk, we maintain our desire to have high-quality Fixed Income exposure.
TIPS have done very well given negative real interest rates on the back of rising inflation. However, we again note that the market appears to be pricing in transitory inflation. The TIPS break-even curve is lower at the longer end than those in the nearer term (inversion). In the past, an inverted TIPS break-even curve has forecasted lower future inflation. The easy money has been made here, but TIPS remain a worthwhile portfolio diversifier. With the 1-year to 10-year TIPS breakeven spread around -130 basis points (as of this writing), the market appears to believe the Fed will not let inflation get out of control. That means the risk worth hedging could be that the Fed turns a blind eye and inflation indeed proves sticky.
Municipals are mostly interest rate products with a tax kicker. Since the change in administration, municipal ratios (the yield of muni as a percentage of a comparable maturity Treasury bond) have fallen substantially (implying municipals have richened). This is mostly prevalent in the front end of the curve, as two-year taxable rates have risen a bit. With that said, we still maintain a favorable outlook on municipals given the tax uncertainty in the coming years. With their unique structures, high relative credit quality and esoteric pricing, professional management can find ways to add value.
Section 05 Real Assets
Over the past year, this document has often contained insight on the potential inflationary impacts of COVID-19. For the first time in more than a decade, investors are now actively discussing inflation as a lasting feature of the economy. We believe real assets can continue to perform well in such an environment.
We have long stated our belief that REITs were the asset class most impacted by COVID-19 and would likely sit at the end of the recovery line. This is exactly what has played out, as REITs were initially the post-COVID-19 laggards when investors contemplated and repriced the intermediate- to long-term impacts from the pandemic. In January 2021, we determined that this reality was largely being reflected in the prices of REITs, and we returned our max underweight to a slight underweight. Over the past few months REITs have surged to become the best-performing asset class as the world began reopening and investors confronted an odd cocktail of heightened inflation with continued low interest rates, resulting in negative real yields.
We do believe there is an opportunity for real yields to rise in the coming months as economic growth remains strong and inflation fears subside. We note that we would likely contemplate any such REIT sell-off that could accompany this as an opportunity to increase our exposure. If inflation proves to be more persistent, REITs will likely provide some level of inflation protection given they hold real assets with pricing power.
Similarly, we continue to hold a neutral allocation in Commodities due to its strong correlation to unexpected inflation. Right now, despite the chatter, the market is pricing in temporary inflation. Building portfolios is about hedging risks, and inflation risks favor Commodities. We note that Commodities have surged near the lead of the asset class performance rankings amid heightened demand, rising inflationary pressures and materials shortages. We realize that the aversion to this asset class remains strong given its disappointing returns over the past economic cycle. However, we believe the future is likely to be much kinder given the economic backdrop shift coupled with undersupply and infrastructure spending.
Within Commodities, we continue to favor broad exposure with a tilt toward gold given our desire to further diversify our portfolios to hedge against unintended consequences. Importantly, we remind that if inflation does rise and the Fed remains well behind the curve, gold will likely provide portfolios with a pressure relief valve given its propensity to be bolstered by negative real interest rates. While we remain relatively optimistic about the future, certainly there are risks, and we believe additional exposure to gold provides diversification benefits.
REITs commonly pay higher dividends than other equities and are likely to remain attractive income-producing assets in 2022. Additionally, valuation levels between the earnings multiples of U.S. equities and U.S. REITs remain attractive, and we view any pullback in the future as a potential buying opportunity. If inflation proves less transitory than expected, Real Estate can be a crucial portfolio hedge against increasing price levels throughout the economy. Even in the face of a rising interest rate environment, we believe REITs offer attractive return and diversification benefits in portfolios. We continue to monitor the REIT market for opportunities to adjust our exposure.
Despite the recent weakness stemming from the omicron variant, Commodities retain their strong relative performance and are up 22 percent year to date, and the underlying fundamentals remain strong.
Energy remains the best-performing sector this year, with WTI crude oil currently priced at $68 per barrel. Surging energy prices were led by natural gas, which has spiked on geopolitical concerns in Europe, low inventories and higher demand. Outside energy, agricultural goods and livestock commodity gains were positive but more muted.
Precious metals have been the worst-performing sector, with gold prices remaining in negative territory year to date after strong gains in 2020. However, the recent omicron variant worries have catapulted gold to the top of the Commodities heap in Q4. Gold serves as a haven for investors looking to avoid volatility in risk assets, particularly in an environment with negative real (inflation-adjusted) interest rates. We would have expected gold prices to rise higher in 2021 as inflation expectations rose and interest rates declined. The long-term relationship between gold and real rates is valid, but there have been sustained short-term periods where the linkage is inconsistent. That said, we find no reason to abandon the anchoring of gold to real yields and continue to expect gold to provide us a hedge against unforeseen economic outcomes.
As we look forward, our forecast is for both U.S. and global growth to remain persistently strong into 2022. This would continue to be a plus for Commodities. It is also important to remember that Commodities are very sensitive to unexpected inflation. Over the past 30 years, Commodities have exhibited the highest positive correlation to inflation of all the major asset classes. In today’s inflationary environment, we think it’s important to have some Commodities exposure within a portfolio. In an era of seemingly unlimited central bank accommodation, Commodities are one asset class that can respond well if inflation exceeds forecasts.
The three primary components of the Bloomberg Commodity Index are energy, metals (both industrial and precious) and agriculture. The benchmark is composed of around one-third of each sector, which means that the benchmark is broadly diversified across the commodity spectrum and ensures that no single commodity has an outsized impact on overall risk and return. The individual components of the Commodity benchmark all have unique characteristics and prices that are determined by different supply and demand drivers within individual markets. However, inflation, economic growth and the direction of the U.S. dollar are the largest drivers for overall commodity prices.
Section 06 Bottom Line: Don't Abandon Diversification
Following the Great Recession of 2007-09, interest rates have remained low, with the 10-year Treasury pushing above 3 percent on only two occasions: a brief spell in 2013 and another in 2018. Both periods of rising rates occurred when inflation was normalizing and economic growth was strong. The 2018 rise appeared to be more permanent, but Fed tightening fears and trade war concerns ultimately dampened economic growth and pushed yields lower. As trade war fears and economic growth worries alleviated in late 2019, the 10-year Treasury yield rapidly rose nearly 50 basis points only to plunge to an all-time low yield of 0.5 percent due to the onset of the pandemic.
As we lurched back toward normal, 10-year Treasury yields rose to 1.7 percent in early November 2021 as the outlook strengthened, only to once again be rattled by omicron fears and Fed tightening worries.
While yields have been low for years this has not impacted Fixed Income investors dramatically because inflation has also been low. Put differently, real yields have been positive (yields less inflation). Contrast that with today, where the recent spike in inflation has caused investors to question the role of Fixed Income once again in their portfolios. The real yield on the 10-year Treasury is currently negative 3.6 percent (1.4 percent yields minus 5 percent annual inflation). When you combine this reality with the perception that all stocks are expensive and poised to deliver low future returns, we are getting questions again about the death of the 60/40 portfolio (60 percent stocks and 40 percent bonds). The phone rings a little more when high-profile investors take to the airwaves and read the obituary of the traditional, old-school 60/40 portfolio.
But readers of this document and our other commentaries are familiar with our revulsion of hyperbole and absolutist proclamations. The death of the 60/40 portfolio is one of those (its death has been hailed many times before). Here’s why we disagree with this sentiment.
First, bonds aren’t just income instruments because they also play a role in liquidity and risk management. Even with low yields, in times of trouble investors flock to high-quality bonds, which serve as a portfolio ballast in churning markets. And if you need liquidity, where are you going to put the money that you need over the next few years? In the volatile stock market? In riskier credits that could experience sharp losses? In cash, which is currently yielding nothing? Despite current limitations, if you need the money in the next few years, high-quality bonds still provide one of the best alternatives.
This all being said, we do agree that the 60/40 model can be improved. Many equate the 60 percent equity portfolio with the S&P 500 Index (U.S. Large Caps and growth stocks). Those with such a view see expensive stocks and bonds that will likely produce low returns moving forward. But they ignore other, less expensive parts of the market that are likely to provide excess returns for patient, value-oriented investors. It’s exactly why we tilt our portfolios — to give our investors the potential to harvest what we believe will be excess returns from these other equity market asset classes. We also incorporate a third asset class into the mix that we believe can do well when equities and fixed income both struggle. Real assets such as Commodities can fill this niche. If inflation is rising and impacting the returns of stocks and bonds, this asset class can provide a hedge and potential upside. It doesn’t upend the 60/40 model; it just tweaks the weightings by adding a “third asset class”.
Ultimately, the underlying premise of the 60/40 portfolio remains intact: disciplined diversification, regardless of market environment. Don’t pull apart your portfolio and judge the merits of each part individually. Think more about how they all perform together in different economic and market environments. Investing isn’t so much about bold proclamations and big bets. It’s more about humility and diversification. If there’s something that separates professional investors from the average retail investor, it’s their focus. While retail investors may focus on big gains, big themes or jumping into memes, professional investors are constantly on guard for what could go wrong and avoiding the big mistakes that could derail a plan. Abandoning diversification or declaring that a long-term investing strategy is irrelevant is one of those risks.
If you have concerns about choppy markets and inflation and want to hear more about other vehicles that hedge a range of outcomes, we urge you to contact your advisor. In addition to strategically allocating your investments, consider including a role for annuities and permanent life insurance in your portfolio, depending on your goals and investment horizons.
Happy Holidays and best wishes for a healthy and prosperous 2022.
Northwestern Mutual Wealth Management Company (NMWMC) Investment Strategy Committee
Brent Schutte, CFA®, Chief Investment Strategist
Michael Helmuth, Chief Portfolio Manager, Fixed Income
Richard Iwanski, CFA®, CAIA, Senior Research & Portfolio Analyst
Matthew Wilbur, Senior Director, Advisory Investments
Matthew Stucky, CFA®, Senior Portfolio Manager, Equities
Doug Peck, CFA®, Portfolio Manager, Private Client Services
David Humphreys, CFA®, Senior Investment Consultant
Nicolas Brown, CFA®, CAIA, Senior Research Analyst, NMWMC Research
The opinions expressed are those of Northwestern Mutual Wealth Management Company as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute individual investor advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non- proprietary sources.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.
Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.
With fixed income securities and bonds, when interest rates rise, bond prices usually fall because an investor may earn a higher yield with another bond. Moreover, the longer the maturity of a bond the greater the risk. When interest rates are at low levels, there is a risk that a significant rise in interest rates can occur in a short period of time and cause losses to the market value of any bonds that you own. At maturity, the issuer of the bond is obligated to return the principal (original investment) to the investor. High-yield bonds present greater credit risk than bonds of higher quality. Bond investors should carefully consider risks such as interest rate risk, credit risk, liquidity risk, securities lending risk, repurchase and reverse repurchase transaction risk.
Investing in special sectors, such as real estate, can be subject to different and greater risks than more diversified investing and may present more financial and other risks than investing in companies of larger capitalizations and more seasoned companies. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments.
Investing in real estate companies entails some of the risks associated with investing in real estate directly, including sensitivity to general and local economic and market conditions, demographic patterns, changes in interest rates and governmental actions.
Investors should be aware of the risks of investments in foreign securities, particularly investments in securities of companies in developing nations. These include the risks of currency fluctuation, of political and economic instability and of less well-developed government supervision and regulation of business and industry practices, as well as differences in accounting standards.
Commodity prices fluctuate more than other asset prices with the potential for large losses and may be affected by market events, weather, regulatory or political developments, worldwide competition and economic conditions. Investment can be made directly in physical assets or commodity-linked derivative instruments, such as commodity swap agreements or futures contracts.
Treasury Inflation-Protected Securities (TIPS) are securities indexed to inflation in order to protect investors from the negative effects of inflation.
The U.S. Large Cap asset class is measured by the S&P 500 Index, which is a capitalization weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The gross domestic product (GDP) is the amount of goods and services produced in a year in a country. The U.S. Mid Cap asset class is measured by the S&P MidCap 400 Index, which is the most widely used index for mid-sized companies and covers approximately 7% of the U.S. equities market. The U.S. Small Cap asset class is measured by the S&P Small Cap 600 Index, a market value weighted index that consists of 600 small-cap U.S. stocks chosen for market size, liquidity and industry group representation. The International Developed Markets asset class is measured by the Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) Index, which is composed of all the publicly traded stocks in developed non-U.S. markets. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. The International Emerging Markets asset class is measured by the MSCI Emerging Markets Index, which is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging-market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey. The Real Estate asset class is measured by the Dow Jones U.S. Select REIT Index, which intends to measure the performance of publicly traded REITs and REIT-like securities. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S. The indices are designed to serve as proxies for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate. The Commodities asset class is measured by the Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, which is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements.
The Consumer Price Index (CPI) examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.